China: Becoming Largest Economy Will Prove Elusive

The IMF predicts that China’s economy will become the world's largest as early as 2016. The IMF's projection must assume, by my calculations, an annual population growth of 0.50% and non-stop 10% GDP growth for the next five years, while the rest of the world stands paralyzed and mesmerized. So much for slightly more complex formulas.

But the world should be resting easy because the U.S. is not the number one economy, based on GDP or GDP per capita with a Purchase Power Parity basis -- the very calculation used by the IMF. According to the CIA Factbook, the European Union – a “country” for these purposes -- is already in first place. The IMF should know that. The U.S. is second and China is third. Thus the accomplishment, if it comes to pass, is a dethroning of the euro zone. As far as GDP per capita is concerned, the U.S. is in 10th place, and Qatar holds the top spot, followed by Liechtenstein and Luxembourg. China holds the unflattering 125th position behind Ecuador and American Samoa, not to mention Ireland (27), Greece (45), and Portugal (56).

But one must take a little trip down memory lane to get a good grasp of why China is where it is today. The paper (pdf) “The Economic Impact of the Chinese Yuan Revaluation” written by Xiaohe Zhang, with The University of Newcastle in Australia, provides a history of the yuan, examines the impact of currency revaluation, and the “Mundell-Stiglitz contention that a significant revaluation of the yuan brings adverse economic impact not only to the Chinese economy but also to the rest of the world,” while pinpointing the 1994 turning point.

[China] committed to improving the trade balance, the authorities intervened in the swap market and repeatedly devalued the official rate from 3.45 yuan per USD in 1986 to about 5.76 yuan per USD in 1993, and eventually unified the official and swap market exchange rates at the prevailing swap price at 8.62 yuan per USD in 1994.

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After the massive devaluation of the yuan, China’s trade balance started to produce positive numbers, as the chart below illustrates. But it wasn't until 2004, as the developed economies started to go for broke and basked in the housing and credit-driven euphoria, that China truly benefited from global trade in earnest, leading to the pressure to revalue the yuan by over 20%, with at least another 20% to go.

On the flip side, and as it relates to currencies, some say that a higher yuan will translate into inflation being exported to western economies. But that’s assuming that the West will keep buying the products and that competitiveness is non-existent. That assumption is as incorrect as it comes.

The latest balance of trade figures, although positive, highlighted one key aspect as reported by Caixin, and the benefit of low labor costs is a social issue that is turning the central planning on its head.

But the Western goose of the golden eggs has left the farm, and government-sponsored infrastructure investments cannot go on forever, especially when many projects are money-losing enterprises, such as high speed railway.

Thus far the party continues, and as Bloomberg reported on March 1, “China’s state-owned railroad is increasing debt sales by 50 percent, driving yield premiums on its bonds to the highest levels in more than six months, as the world’s biggest high-speed network is rolled out.” And this is only one example:

Spending on China’s railways totaled 1.42 trillion yuan over the last two years, 33 percent more than was invested in the previous five, and the government predicts a further 700 billion yuan will be used to fund construction in 2011.

Caixin reported that “Railways Ministry Runs in Red,” and offered that “the ministry, which did not announce its full-year results for 2010, booked net losses of 3.76 billion yuan in the first quarter, compared to 2.96 billion yuan in earnings for the third quarter of last year.” The fourth quarter appears to have been skipped.

A research analyst projected losses for the entire 2010 at around 20 billion yuan, largely due to surging operational costs, with heavier losses expected this year.

During the last three years, China’s GDP has been driven largely by government stimulus and investment into questionable projects to keep the political “status quo” intact, and in the midst of all economic data, I am still trying to figure out the inflation story and the repeated reserve increases, while new loans keep climbing.

But there’s always someone with an opposing view, and Ting Lu with Merrill Lynch Hong Kong is one of them. According to Forbes, he views inflation as a fixture that will stay embedded in China’s economy for a long time, and he views it as beneficial.

Higher food prices will help to lift farm income and thereby relieve one of China’s most pressing social problems, he says. Spreading money around wider will also be good for China’s long-term economic prospects, even if it squeezes urban consumers in the short run, he reasons.

Higher food prices will certainly help producers in the short-term, but increased productivity – output per labor hour – is the true solution, and that is yet another economic shortcoming that is often forgotten. As far as “spreading money around” is concerned, I am in a different camp, because we’ve done that elsewhere and it didn’t end well.

CNBC reported on January 14 that “China Has $1.5 Trillion ‘Hidden’ Debt: Lawmaker,” or about half of the country’s foreign currency reserves. The report starts with the following excerpt.

Billions of dollars of debt racked up by local Chinese governments during their investment sprees are likely to sour as the projects they finance near completion, Yin Zhongqing, a prominent Chinese lawmaker, said this week. In an interview with Reuters Insider, Yin said local governments had incurred at least 10 trillion yuan ($1.5 trillion) of "hidden" debt, which they have concealed by creating thousands of investment vehicles that serve as borrowers.

And as we undertstand how home sales provide an impetus for general consumption, regardless of geography, Caixin reported a 10.4% drop in house sales in April. "Of the 47 major cities tracked by real estate website Soufun.com, over 90 percent saw home sales falling on a year-on-year basis last month."

What is China’s main obstacle to accomplish what many view as a given? China itself. But I’m not very concerned with the number one spot, and I want to live in the world’s fourth largest economy by GDP per capita (Purchasing Power Parity): Bermuda.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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